Let’s begin our forensics on Chinese trade with understanding a different people and business operating system…
In the United States we are a fiscalized system. Whoever is the President, Mark Zuckerberg stays in office. Corporations are fused to our ‘democratic’ operating system. We idealize (at least rhetorically) the individual and are conditioned to believe that the State and Corporations exist to serve.
In China it’s a political system. Political leadership turnover has enormous effect and corporate heads are rotated in and out. The political leaders are fused into the corporations. The China Communist Party (CCP is the one state party) is idealized and the components (people and corporations) exist to serve. Xi Jinping, the General Secretary of the CCP uses all the coercive force of China to emphasize and punish non-compliance with the “Four consciousnesses”
It refers to:
“political consciousness” the primary consideration of political priorities when addressing issues
“consciousness of the overall situation” the overarching priorities of the Party and government
“core consciousness” to follow and protect Xi Jinping as the leadership “core”
“integrity consciousness” the need to fall in line with the Party
Peeling the Chinese trade onion
China has a dual currency system.
The ‘onshore’ currency is the Renminbi (RMB) or yuan and also called the CNY. It is only used to pay bills on the mainland. The onshore currency can’t be used for international transactions. There is no real market for the exchange rate, instead the People’s Bank of China (PBOC) comes up with a price every day thru an unknown equation, and then trades around it.
The “offshore” currency, also called the yuan or CNH, is used for international clearing and trading. The CNH has a completely separate set of demand and supply conditions from the onshore RMB
The Chinese have it both ways, huge inner stimulation to appease the people. Strong external currency to maintain purchasing power outside.
By controlling the supply of CNH (offshore money) outstanding China can create a CNH shortage. They’d just buy the offshore currency to drive the value/price up.
Alternatively they can sell the offshore currency, flooding the market with CNH to drive the value/price down. For example, when a foreign Purchaser of goods has to settle the transaction, and there’s a shortage of settlement currency (CNH), his/her cost goes up.
Conversely, if there are boatloads of CNH available his/her cost goes down.
It’s impossible to simultaneously have
full capital mobility
fixed exchange rate
independent monetary policy.
But they’ve done it…
How this affects trade. Bear with me, we’ve got to get a little technical
By managing the global supply and therefore the exchange rate of the onshore currency needed by ‘outside’ companies doing business with China, the Chinese Government has been able to generate US$ trillions of additional compensation for their net exports as well as purchase US$ Trillions of EU/Western/Offshore assets at a significant discount.
Simultaneously, the Chinese Communist Party, the one party owner of the State, has been selling Mainland (RMB Denominated) Assets to EU/Western/Offshore Businesses and Investors at a grossly inflated price.
And that’s a bigly reason for the huge trade imbalance
Economic outlook, debt levels, tail/headwinds, interest rates, politics, supply/demand for the currency, current account balances/deficits and a witch’s brew of other factors all contribute to determining exchange rates. That’s what it means when a currency floats.
The RMB (the onshore only currency) is the only currency issued by a major economy that does not float.
It’s value is untethered to the health of its’ economy and other considerations in the marketplace. It’s currency exchange value is ‘made-up’ by the Peoples Bank of China
(Why can’t I pay my bills in shit money and collect the money I’m owed in US dollars)
Let’s keep peeling this onion, it’s that important
When a US company buys goods from China, he/she pays in dollars.
The banks exchange the dollars for CNH (offshore money), then…
the banks must convert the CNH to CNY (from offshore money to onshore money)
then the exporter of goods receives CNY (to pay staff, bills, etc.,).
The same happens (in reverse), when a Chinese company purchases US goods
The Chinese company pays in CNY (the onshore currency), then…
his/her bank exchanges the CNY for CNH (the offshore currency)
and eventually to the FOREX (foreign exchange markets used to sell international transactions) necessary to complete the transaction.
The Peoples Bank of China (PBOC), because of their gigantic foreign currency reserves (all the world’s money that is used to pay for Chinese goods), can make the value of the CNH virtually any number they like. Like a thinly traded stock, the PBOC can buy up all/most of the outstanding CNH making it difficult/expensive to close transactions. Conversely, they could flood the market with CNH driving the value of the CNH down.
Lots of fishy’ness
Let’s take a look at the change in the Peoples Bank of China monthly FOREX balance (FOREX is the over-the-counter market in which the foreign currencies of the world are traded. It is the largest and most liquid market in the world)
You’d expect that since China average monthly net Exports and Foreign Direct Investment (FDI) are bigly positive, that their Forex (foreign currency) balance would be increasing. There is still more “money” flowing into China than is flowing out. Yet, the Peoples Bank of China FOREX balances continue to decline.
For those unequipped with the jargon of finance, M2 is an important number, it is the total value of a country’s coins and notes in circulation, short-term time deposits in banks and 24-hour money market funds and other money equivalents that are easily convertible into cash.
Now, let’s take a look at the Peoples Bank of China FOREX reserve balance compared to China’s M2 and CNH in circulation,
China’s M2 (onshore money) has continued to accelerate. It is a $US 9.5 Trillion increase since 2012. China has printed the equivalent of the entire US Money Supply in less than five years.
All the while, FOREX reserves and CNH (offshore money) balances have declined significantly.
Peoples Bank of China FOREX balances (all of the reserve currency accumulated over the last decade while China became the world’s manufacturer) have declined US$ 500 Billion (25%) since 2015.
CNH Balances (offshore currency) have declined nearly US$80 Billion (33%) from their high in July of 2015.
The offshore money supply is moving in a wildly different direction than the onshore money.
In comparison to money supply exchange rate relationships…
The United States Federal Reserve banking system has increased US M2 by 6% (compounded) since the 2008 financial crisis. (We’ve created lots of new money just by printing it)
The Peoples Bank of China has increased China’s M2 at a whopping 15.5% Compounded annual growth rate during the same period.
Yet, the exchange rate has remained relatively rock solid since 2010.
Without the dual onshore/offshore currency system, where the Peoples Bank of China is able to shrink the “Usable” offshore currency (CNH) in circulation, propping its value to absurd levels, while simultaneously flooding the domestic streets with its onshore money, this US$ exchange rate relationship would simply not be possible.
And that’s a bigly reason for the huge trade imbalance
Now, let’s take a look at what a “real” currency relationship might look like if it were not tampered with by the Peoples Bank of China. Let’s compare the Euro to the US$…
When we compare M2 for the Eurozone (4% Compounded Annual Growth) to the US$ (6% Compounded Annual Growth) we can draw some reasonable observations.
Despite the higher rate of increase in US M2, the Euro has actually declined in value. It’s worth roughly 75% of what it was worth in January of 2008
In 2008 I’d get $1.50 when I cashed in a Euro and today I’d only get $1.10, even though there are substantially/relatively more dollars available today than there were back in 2008.
When there is ‘more money’, it should be worth less. That’s the physics of currency exchange rates in a free market. But to China, economic physics don’t apply. China onshore money is gravity defying.
Remarkably, because of the State managed price/wage controls, all of this money printing isn’t causing inflation.
China’s (fake) Consumer Price Index (CPI) has remained under 3% and declining since 2012. Based on the wild expansion of the money supply, we would not think that this could be plausible, but yet, all of this money printing is not increasing consumption in any meaningful way. If people have more, in a sane world without a dual currency system, they spend somewhat more, right?
Consumption, as a % of Gross domestic product (the total value of goods produced and services provided in a country during one year) if you believe the silly, guaranteed, rock-solid 7% annual GDP figure that China claims, has remained constant for the last few years at roughly 50% of GDP.
Moreover, as is relatively common for the NBS (National Bureau of Statistics of China ), when the figures don’t track with what they’d like them to be, they either pull numbers out of a hat, or stop publishing the data altogether.
The last time Total Consumption as a % of GDP was published was as of 12/31/2014. Amazing that both prices and domestic demand for goods is relatively flat when compared to China’s published (fake) GDP given the monumental M2 increase.
China has become a net exporter of capital. More capital (money) is going out than is coming in. China’s Outbound Direct Investment (ODI) spiked to $103 Billion in the first seven months of 2017 year registering a 61.8% increase year over year (YOY) and overtook the Foreign Direct Investment (FDI) of $77 Billion. This trend is expected to continue, China is expected to be the world’s largest global investor by 2020.
When we compare global settlement transaction volume to total RMB in circulation we see a stark contrast.
While RMB (onshore currency) settlements are relatively small and declining, China’s M3 (M3 is a measure of the money supply that includes M2 as well as large time deposits, institutional money market funds, short-term repurchase agreements and larger liquid assets) is increasing dramatically.
China’s M3 in circulation has nearly doubled in the last five years to US$25 Trillion, nearly tripling in the last eight years.
During the same time frame, by comparison:
US M3 has increased 40% and 50% respectively to roughly US$14 Trillion.
Why do the Chinese need so much currency (US$10 Trillion more than the US) to run their much smaller economy?
When we compare the GDP (total value of goods produced and services provided in a country during one year) for China and the US we see that the amount of Gross Domestic Product (GDP) created per unit of money is decelerating as we’d expect. As money/debt creation outpaces GDP, the money is used to service existing debt, fund bubbles and generally kick the can down the road.
With the M3 growth we’d think that the Chinese economy would be experiencing both significant consumer price inflation (CPI) inflation and an erosion of the exchange rate.
Interestingly, in defiance of economic physics, that hasn’t happened.
Despite the dramatic growth in M3 the China exchange rate has remained relatively constant with no detectable relationship to M3, since 2010.
The reported Consumer Price Index (cost of living index) has actually declined.
Generally, all else being equal, as the money supply increases you’d expect inflation and a weaker currency. Again, if the Chinese were operating as a market driven economy and a floating currency, this would not be possible.
What is the exchange rate of the RMB?
Because the RMB (onshore currency) value is based on a tiny offshore sliver of the total amount of currency in circulation, we are faced with the proposition that virtually every economic relationship/conversion between the Rest of the World (ROTW) and China is based on a manipulated currency.
Right now, the only value the RMB has to the rest of the world (ROTW) is to facilitate trade and investment with China.
The dual currency system makes the value and amount of currency in circulation on the mainland (the “Reserves”) irrelevant to the rest of the world.
What matters to the ROTW in terms of supply and demand is the accessible amount of RMB available to settle transactions with China.
Unlike the Dollar, Euro, Pound and Yen, which can be converted to most currencies instantly, almost anywhere in the world (except mainland China) there are only a few places on the planet that the Chinese Communist Party, the one-party owners of China allows RMB (CNH) to hide.
The RMB, onshore money, located in clearing centers around the world has been declining. China has created a shortage in it to drive its price up.
Total “Offshore” currency available for international transactions is roughly equivalent to RMB 1.15 Trillion and represents roughly 0.7% of all RMB in circulation, down from about 1.6% in 2015. There’s just not a lot of onshore money to go around, so, its price goes (artificially) higher
What’s happening to all of that foreign currency that should be coming into China’s coffers?
All of the money that is being paid to the manufacturer to the world called China (US$1.158 Trillion) should be showing up on the Peoples bank of China Balance Sheet. But both Foreign Reserves and Assets are declining.
The reason the Peoples Bank of China on-balance-sheet balances aren’t increasing is that the world’s currencies never gets to the mainland in the first place.
They use funny money within China. Its that crazy dual currency system
Let’s take a look at the chart below. It illustrates what’s happening in the hypothetical when Apple buys a shipment of iPhones from FOXCONN.
Apple takes delivery of the iPhone shipment and has to pay FOXCONN
Apple has dollars and FOXCONN wants the onshore money needed so it can pay wages, raw material costs, utilities, kickbacks, etc, in China
Apple has an account at JP Morgan and sends US$ wire instructions
The Bank of China (FOXCONN’s Bank) receives the US$ and forwards the equivalent onshore money to FOXCONN’s Bank of China Account on the Mainland.
The Bank of China (Hong Kong Branch) needs to replace (like the way two cash registers settle money when one register needs singles and gives the other a large bill to break) the onshore currency so they borrow the RMB from the mainland home office
The Hong Kong branch can now loan out or invest their US$ deposits.
Not coincidentally there have been thousands of Chinese owned offshore shell companies created to facilitate movement of wealth from the mainland. If you’re lucky and mobbed enough to be one of the China elites, do you want their funny money that can only be spent at home and is a disaster waiting to happen, or do you want to trade it for some of the real stuff?
And this smart thinking has created an industry of vehicles to take all that money and invest it primarily in US/EU/HK/etc. Financial Assets and Real Estate.
It is a tsunami of Chinese play funny money and neither the FED nor the Treasury has any authority or tools to prevent a US citizen or company from selling assets to any foreign investor. The State Department has limited powers through CFIUS for politically sensitive businesses (Tech, Defense, Infrastructure, Energy, etc.)
Unlike the Chinese government, the US Government has no SOEs (State Owned Enterprises) that can be funded and used to acquire assets all over the world. Darn it.
(This also helps me, and you, better understand how absurd companies with absurd business models like Alibaba, Ant Financial, Tencent, Evergrande, Fosun, AnBang, JD.com, HNA that operate out of the reach of the SEC, FBI, US Courts and civil sanctions are actually China Communist Party (CCP) sponsored vehicles created and designed to convert the onshore monopoly money into hard Western assets at a discount. China also bigly uses Amazon and Walmart for this)
So what have we woven?
China’s dual-currency system enables the Chinese Central Bank to manage the value if its global currency (CNH) to a benchmark which is becoming more removed from its real economic value by the day.
This artificial strength, allows Chinese sellers of goods, as well as Chinese Investors to trade their onshore (garbage) money for real, reserve currencies/assets
The rapidly expanding money supply, debt levels and massaged NBS/PBOC data effectively mask the accelerating deterioration of China’s onshore “real” economy.
Lastly, if you’re the overly inquisitive type, you may want to know where all of this newly printed onshore money, about US$ 9.5 Trillion, in the last few years, going?
Let’s start by discussing where it’s not going…
Chinese workers have had a relative bonanza in wages.
Average Wages have increased at a rate of roughly 11% a year since 2011
Wages have increased from US$6,531/yr in 2011 to US$9,549/yr
In 2015, a total payroll of US$7.4 Trillion when this figure is applied to 775 million employed Chinese workers. This yields a US$2.4 Trillion pay increase over 2011
So what do all of the employees do with this US$2.4 Trillion annual windfall? They invest it of course, but sadly, it’s all in China and in that strange onshore money they have.
Disposable income has also increased at a 10% clip, from US$3,300 a year to US$4,800/yr., (or as of 2015, US$1.1 Trillion annually).
Household debt in China has increased (Compared to China’s M2) by a multiple of 5x to nearly US$4.2 Trillion since the 2008 base year.
Household debt is now roughly 40% of (fake) GDP. The rate of increase is accelerating.
All of their money (the money that isn’t privileged enough to get out of the country and get traded for real currency) goes back into the Chinese Banking system, buying un-guaranteed Wealth Management Products (WMP’s) that pay an oddly high interest rate and are Madoff like promoted and sold by their megabig, trusted Chinese Banks.
If you are at the top range of the Chinese pecking order, you can afford to send your kids to US Schools. You start buying up all of the stocks/bonds and New York Condos you can get your hands on, because…
you know you are trading that strange onshore currency for real assets.
H/t Deep throat